For retail companies, load-shedding has had a substantial impact on their operations, leading to decreased sales, increased costs and potential damage to their brand reputations. This, in turn, has weighed on retailers’ share prices (as shown in Graph 1). But could the recent sell-off of their shares induced by the negative news be presenting a buying opportunity for long-term investors?
Graph 1: Retailer Share Prices in 2023
(Re-based to 100 at 1 Jan 2023)
All retailers are experiencing slower sales growth, higher costs, lower margins and either higher capital spending (capex) or are having to re-allocate capex from growth initiatives to installing alternative power solutions. However, all retailers are not equally impacted - food retailers are far more energy-intensive than apparel and drug retailers, as they need to maintain their cold chains in both their distribution centres and store networks 24/7.
Slower sales growth
Load-shedding is changing consumers’ purchasing behaviour, and due to the frequency of purchase, food retailers are most impacted. Consumers are adapting where they shop depending on load-shedding schedules, shopping more regularly and shifting the mix in their baskets from fresh to more ambient food products to avoid food waste at home. Consequently, food retailers known for their superior cold chain management are gaining market share. The inconvenience load-shedding poses to shopping in stores is also accelerating the use of online shopping, which is in turn shifting market share to those businesses with superior e-commerce offerings, namely Checkers with Sixty60 and The Foschini Group with Bash.
Demand-planning becomes substantially harder due to the variability of load-shedding stages, as retailers try to ensure they have the right products, in the right quantity, at the right stores. Mistakes with demand-planning lead to both missed sales opportunities and higher wastage (which impacts gross profit margins). In addition, suppliers’ production abilities are being hampered, restricting the volumes and range they can manufacture and resulting in less product on shelf. Small suppliers are requiring financial assistance to invest in backup power solutions, which retailers are providing to ensure supply.
While food retailers use generators, apparel retailers typically use inverter and battery solutions for backup power. Most of the apparel retailers’ systems are designed to cover Stages 3-4. At higher levels of load-shedding, the batteries don’t have enough time to re-charge between outages, requiring the retailer to either stop trading or trade out of a dark store. Not all apparel stores have backup systems, hence load-shedding has a greater impact on their revenue generation. For example, Mr Price has the lowest coverage of backup power of the listed apparel retailers, which we believe was a key contributor to them delivering the worst festive period trading update.
Lower gross profit margins
Both food and apparel retailers are experiencing gross profit margin pressure. Almost all apparel retailers increased inventory levels in the lead-up to the festive period in 2022, which is likely to lead to higher promotional activity and increased markdown levels. At the same time, disruptions to food retailers’ cold chains are leading to higher wastage. In addition, the Food sector is experiencing high input inflation and companies are not fully passing price increases on as they try to preserve their value offering in a constrained consumer environment. Despite this price investment, food retailers are experiencing negative volume growth (except for Shoprite). All the above impacts are negative for gross profit margins.
Elevated operating costs
While apparel retailers have not experienced a significant increase in operating costs due the mix of backup power solutions being heavily skewed to inverter and battery solutions, food retailers have reported substantial increases in operating costs from their use of generators. Their cost is reported to be at least five times higher than the cost of grid-supplied power. For example, Shoprite’s average monthly diesel spend has skyrocketed from R16m in the first half of financial 2022 to R93m in the first half of financial 2023 and most recently in January 2023 to R150m. If load-shedding continues at a similar rate, they will spend approximately R1.5bn on diesel in their 2023 financial year, reducing their operating margin by just under 1.0%.
Our concern with the food retailers is that operating margins are already relatively low (mid-single digits); hence the negative leverage impact from materially higher operating costs on their earnings will be substantial. Retailers are likely to pass these higher costs on to customers, increasing the risk of high inflation being stickier and volume growth being even more negative. This is likely the key driver of why Pick ‘n Pay’s share price has fallen 30% in 2023 (see Graph1), as they have the thinnest margin.
Capex is being re-prioritized
Like all businesses in South Africa, retailers are having to accelerate their roll-out of backup power solutions. Those companies with strong balance sheets (including Shoprite, Woolworths, The Foschini Group and Truworths) are able to fund this in addition to their current capex plans. However, retailers with weaker balance sheets (like Pick ‘n Pay) are having to re-allocate capex from growth projects (such as the rollout of their Ekuseni strategy) to this energy expenditure, thereby protecting current sales at the expense of future growth.
Is the market too pessimistic?
The entirety of the impact of load-shedding on retailers’ sales growth, costs and margins is difficult to forecast due to the fluidity of the level of load-shedding being implemented and the uncertainty of how long it will persist. What we do know is that these high levels of load-shedding are negative for retailers’ earnings prospects and that the risk of load-shedding getting worse over winter 2023 is high.
While the near-term outlook does look dire, we think the load-shedding challenges will ultimately prove transitory given the amount of investment in alternative power sources by the private sector (both businesses and households), combined with Eskom supply improving later in 2023.
Yet the market has sold off all retailers indiscriminately, including companies with operations in the UK and Australia not impacted by loadshedding. Valuations seem to be pricing in the current poor conditions into perpetuity, rather than expecting the load-shedding challenges to be overcome in the medium term. Both the SA Food and Apparel sectors are trading below the forward price-earnings (PE) multiples they traded at during the height of Covid, when stores were closed and earning zero revenue. In our view, this is overly pessimistic for the sector on a medium-term view and hence provides a good buying opportunity to select retail stocks.
With valuations currently low versus their long-term averages and the market pricing in what we believe are pessimistically high risks over the medium term, especially for Apparel retailers, we believe the risk-adjusted return potential is very attractive for select retailers. While there are likely to be more hard times for the sector ahead, especially over the winter when electricity demand is at a high and reliable power sources remain in short supply, retailers will expand their alternative power supplies and improve their ability to manage through load-shedding in the not-too-distant future. For valuation-based investors like us, it is important to invest with a view to the medium- and longer term and seize episodes of mis-pricing when they arise, like the present. DM/BM
By: Damon Buss, Equity Analyst at M&G Investments